Gilts May Stutter But Should Avoid Sharp Losses Next Year – Analysts

By Neelabh Chaturvedi

U.K. government bonds have wobbled in recent days, but despite a gloomy economic backdrop, many investors are not anticipating a surge in the government’s borrowing costs next year.

Investors are now demanding half a percentage more to buy U.K. government bonds maturing in 10 years instead of German government bonds of the same maturity, the highest premium in eight months. The difference in bond yields between top-rated gilts and French debt has almost vanished despite two of the three main credit rating agencies stripping France of its cherished triple-A rating this year.

To be sure, yields on bonds sold by other countries seen has harbours of safety in times of tumult–Germany, the U.S., and to a lesser degree France–have also climbed in recent weeks as hopes that U.S. lawmakers will avert growth-crimping spending cuts and tax rises have lifted riskier assets.

Worries of a Greek exit from the euro zone in the immediate future have also abated. Haven government bonds with their low yields are looking pale in comparison.

But gilts yields have risen more sharply. The yield on the benchmark 10-year gilt Tuesday climbed to a two-month high of 1.93%. Yields have not been above 2% since early May.

In addition to overseas developments, gilts have been rocked by a confluence of domestic factors. Bond purchases by the Bank of England stopped at the end of October. Earlier this month, the Office for Budget Responsibility projected the government’s borrowing needs to continue to swell as weak economic activity weighs on tax receipts.

Finally, Standard & Poor’s last week joined Fitch Ratings and Moody’s Investors Service in lowering its outlook on the U.K.’s debt rating to negative.

While gilts could well lag moves in German debt in 2013 due to these factors, a central bank that is still cautious about the growth outlook and may yet resume gilts purchases, the large size of the U.K.’s government bond market, and the presence of domestic financial institutions with deep pockets should help avoid a sharp sell-off, market participants said.

“Gilts have underperformed other haven markets but I don’t think alarm bells are ringing at this point,” said Nick Gartside, who manages $148 billion of assets as the head of international fixed income at JPMorgan Asset Management, adding that he does not expect gilt yields to rise sharply.

In a research note, interest rate strategists at the Royal Bank of Scotland advised clients to sell 10-year gilts and buy Bunds instead. They expect the yield premium between 10-year U.K. and German debt to widen to 0.80 percentage points. U.K. government bonds maturing in 10 years currently yield 0.54 percentage points more than their German counterparts and briefly enjoyed lower yields than German debt last year.

“If the perceived fiscal concerns become exacerbated, a spread of 1 percentage point is perfectly feasible,” the RBS strategists said.

According to the European Commission, only Ireland in the European Union is forecast to run a bigger budget deficit next year. At 7.2% of gross domestic product, the U.K.’s budget deficit would be more than twice the deficit as a share of output that the Commission expects France to run in 2013.

Yet despite the somber backdrop, many investors are not rushing for the exits.

The BOE used to snap up more bonds than the debt office was selling, but now private investors are now being asked to step in. How smoothly private investors shoulder the burden of supporting gilts in the absence of buying from the central bank could influence moves in gilts. Overseas investors appear enthusiastic for now, having snapped up £14.12 billion ($22.87 billion) more gilts than they have sold this year. Domestic pension funds and insurance companies should also remain big buyers to meet demands imposed by regulators.

And if a rise in the government’s borrowing costs threatened to derail the recovery, the BOE may be inclined to buy more gilts as well.

“A rise in government bond yields will push up the cost of capital and imperil the monetary transmission mechanism so a sell-off in gilts will also increase the likelihood of another round of asset purchases from the BOE,” said Mr. Gartside, who currently has a neutral view on U.K. government debt.

While a ratings cut could well materialize, any impact is likely to be fleeting as only a handful of buyers restrict their investments to instruments rated triple-A. Given the spate of rating cuts in recent years, the pool of countries with secure ratings and bond markets that are large enough to accommodate flows from big investors has already shrunk.

France and the U.S. both weathered rating downgrades with minimum fuss.

“Interestingly, if we are moving into a period where global bond yields move higher, we think that there may be interest in being long gilts in cross-market positions versus other markets, most notably core Europe,” said Moyeen Islam, U.K. interest rate strategist at Barclays.

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